Fear Companies Lurking in Dark Financial Shadows: Simon Johnson

By Simon Johnson -
May 15, 2011

On the face of it, Glencore
International AG doesn’t look too scary. With about $80 billion
in assets, the Swiss-based commodities trader is a lightweight
in comparison to global megabanks like Goldman Sachs Group Inc. (GS),
one of its trading rivals. Goldman has assets more than 10 times
Glencore’s, is more leveraged and has less capital.

What Glencore’s rivals are really worried about is
competitive advantage. It’s about to sell $11 billion in shares
through an initial public offering in London and Hong Kong. That
fresh capital will allow Glencore to expand at a time when its
Wall Street competitors’ hands are tied. Glencore doesn’t face
the same limits that banks do in proprietary trading, capital
reserves, leverage and compensation. This may be unfair, but
it’s not the right reason to subject Glencore to the same tough
regulatory regime as banks, nor the right lesson to draw from
our recent experiences.

The real question regulators should ask is this: How much
of a risk would Glencore pose to the world’s financial system?
To use the terminology proposed by Mervyn King, governor of the
Bank of England, is Glencore “too important to fail” -- meaning
that its bankruptcy would bring down other significant parts of
the financial system or real economy?

Marc Rich Connection

Glencore was founded by the secretive Marc Rich, who fled
the U.S. for Switzerland in 1983 just before being indicted on
tax evasion and other charges. He sold the company in a
management-led buyout in 1994. President Bill Clinton pardoned
Rich in 2001. Today Glencore trades and produces minerals and
metals like zinc, aluminum, cobalt and coal, as well as grains,
cotton and sugar. It owns refineries and drilling rigs and holds
large stakes in other mining companies.

Glencore also has a large amount of capital and little
leverage, judging by its shareholder equity, which is worth 25
percent of assets. Goldman claims equity worth about 14 percent
of assets, counting only risk-weighted assets. But on an apples-
to-apples basis (counting unweighted assets), Goldman’s
shareholder equity is closer to 7 percent.

Little Threat

There is little sign that a government would feel the need
to save Glencore and protect its creditors if it were on the
brink of collapse. A restructuring of its debts should not be
disruptive to the world economy. Based on the limited
information in Glencore’s 2010 annual report, even its
derivatives book seems unlikely to create system-wide risk.

Still, this could change quickly. Derivatives are the wild
card. Glencore almost certainly will qualify for the so-called
end-user exemption under the Dodd-Frank financial reform
legislation, meaning that it may not have to follow new clearing
and margin requirements (although these rules are still under
discussion). It would be relatively easy for a firm with
Glencore’s balance sheet and insight into the physical side of
commodity markets to ramp up its involvement in the financial
side of commodities.

We do not want commodity traders like Glencore, Cargill
Inc., Paris-based Louis Dreyfus & Cie., an oil major or any
other nonfinancial company to be tempted to take financial risks
that are big relative to the size of the system.

Even supposedly expert financial firms can destroy
themselves with the mismanagement of risk -- a process made
potentially even more devastating to everyone involved through
derivatives.

Lehman’s Lessons

Remember that Lehman Brothers Holdings Inc. (LEHMQ) was not a
megabank -- its balance sheet was about one-fifth the size of
Citigroup’s and the largest European banks’. But Lehman’s web of
connections through derivative transactions turned out to pose a
system-wide threat -- about which the Treasury Department and
the Federal Reserve were completely unaware until the day after
Lehman went bankrupt.

The end-user exemption should be interpreted narrowly and
applied evenly. If Glencore or a similar company wants to engage
in financial speculation or market-making, those activities
should be walled off from their physical operations and
legitimate hedging needs, as my MIT colleague John Parsons has
been arguing.

Regulators need as much visibility as possible into
derivatives transactions around the world. The major players in
these markets -- including firms like Goldman -- do not want
transparency, primarily because they don’t want their pricing
structure to be widely known.

Open Secret

It was transactions between the big Wall Street firms and
largely unregulated mortgage originators that brought us the
subprime crisis. The open secret of Wall Street is that the
“shadows” are often made possible and profitable by the big
banks. One example: structured investment vehicles, the
undercapitalized, off-balance-sheet entities that large banks
created in 2007 and 2008 to house subprime mortgage investments.

The Treasury Department has been pressing hard to lighten
the transparency requirements on derivatives markets, including
most recently with its baffling decision to exempt foreign
exchange swaps from clearing requirements. The best way to deal
with potential shadows is to shine a bright light on all
markets. Restricting who can avail themselves of the end-user
exemption is one very good way to ensure that the shadows do not
get too dark and that stand-alone commodity traders do not
become too important to fail.

(Simon Johnson, co-author of “13 Bankers: The Wall Street
Takeover and the Next Financial Meltdown” and a professor at
MIT’s Sloan School of Management, is a Bloomberg News columnist.
The opinions expressed are his own.)

To contact the writer of this column:
Simon Johnson at sjohnson@mit.edu